August 19, 2008

Which marital trust is the "gap" trust?

Query: We practice in a state that has a separate estate tax exclusion amount (we're "decoupled"). For that reason, we typically create two marital deduction trusts using WealthDocs's formula language: Marital Trust One, and Marital Trust Two. Under WealthDocs, which trust is the "gap" trust? And then how are these things administered?

Response: First of all, understand that if your state allows you to make a separate state QTIP election, then it's not necessary to create two marital trusts. You can fund the Marital Share with an amount necessary to reduce all death taxes to the lowest amount (federal and state), and then make separate QTIP elections on the estate tax returns when the client dies. On the state estate tax return you'll make a full QTIP election; on the federal estate tax return (706) you'll make a partial QTIP election (over only the amount necessary to minimize federal tax).

But if your state does not allow separate QTIP elections, WealthDocs allows you to elect to reduce all death taxes (federal and state) to the lowest possible amount, and then divide the Marital Share into two separate marital QTIP trusts: QTIP One equal to the amount necessary to reduce federal estate taxes to the lowest possible amount, and QTIP Two, a "gap" QTIP trust equal to the balance of the Marital Share. The grantor's trustee will make the QTIP election on both QTIP trusts (the federal QTIP and the "gap" QTIP) on the grantor's 706 and the state death tax return. It takes a little post-mortem finesse to maximize the tax opportunity by having the "gap" QTIP election disregarded (declared void on the 706) when the surviving spouse later dies. (Revenue Procedure 2001-38) (Note that the IRS won't allow the trustee to disregard a "partial" QTIP election. Hence the two separate QTIP trusts.)

Here's how the division is made:

First, the trust divides the estate into a marital share and a non-marital share. The marital share is created by first reducing ALL estate taxes (federal and state). The marital share is then further divided into two separate QTIP trusts.

QTIP One holds the amount necessary to minimize the federal estate tax. In computing its fractional formula, the numerator is "the minimum value...sufficient to reduce the federal estate tax to the lowest possible amount." QTIP Two thus becomes the "gap" trust; it holds the rest of the marital share.

Consider the following hypothetical:

Tom Client's gross estate = $10,000,000. His wife, Cindy, survives him, and Tom's trust contains a fractional marital "two-QTIP" formula. Tom dies while a resident of a state that has a $1,000,000 estate tax exemption.

The marital share is first computed to hold $9,000,000. (The minimum amount necessary to reduce ALL death taxes to the lowest possible amount.)

The nonmarital share holds the balance, or $1,000,000.

The marital share ($9,000,000) is then further divided:

QTIP One is computed to hold $8,000,000. (The minimum amount necessary to reduce FEDERAL death taxes to the lowest possible amount.)

QTIP Two is computed to hold $1,000,000. (The balance of the marital share, or the state "gap" trust.)

If Tom's state allows separate QTIP elections, Tom's trustee elects QTIP treatment on QTIP One only for the 706, because that's all that is needed to minimize federal estate taxes. Tom's trustee elects QTIP treatment on both QTIP One and QTIP Two on the state estate tax return, because both are needed to minimize the state death tax.

If Tom's state does NOT allow separate QTIP elections (like New York or Minnesota), then Tom's trustee must take the QTIP election on both QTIP trusts One and Two. But when Cindy later dies, Cindy's trustee relies on Rev. Proc. 2001-38 to disregard the QTIP election on QTIP Two, because it was not needed for federal estate tax purposes.